Saturday, October 30, 2010

Even those of you who don't enjoy charts will see the signs of an exhausted market just waiting for the sell signal from the Powers That Be to roll over.Standard-issue financial pundits forget that "surprising" declines benefit those same select hands which kept the market lofting higher the past few months as volume (i.e. broad-based appetite for equities) declined.

The easiest way to make large profits is to go short when everyone else has been lulled into complacency/mild bullishness, then engineer a sharp downturn that triggers stops all the way down. Once the complacency has been replaced by fear and angst, then scoop up shares which have been discounted.

Rinse and repeat.

This is not investment advice (please see the HUGE GIANT BIG FAT DISCLAIMER below) but is that a voice crying "Look out below!" I hear? Previous entries on the same topic:

Recommended Books and Films has been updated and now includes a new category of books on The Global Financial Meltdown. Lots of fascinating titles to browse....

My apologies: due to my workload I have fallen behind on my email once again. Your correspondence is greatly appreciated even when I am unable to respond in a timely manner.

Special podcast: Steve over at Two Beers with Steve was generous enough to invite me back to discuss topics of great importance to both of us and to you: health, diet, fitness and taking charge of our own lives. Please give it a listen: Two Beers with Steve podcast.

If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.

HUGE GIANT BIG FAT DISCLAIMER:Nothing on this site should be construed as investment advice or guidance. It is not intended as investment advice or guidance, nor is it offered as such. It is solely the opinion of the writer, who is NOT an investment counselor/professional. All the content of this website is solely an expression of his personal interests and is posted as free-of-charge opinion and commentary. If you seek investment advice, consult a registered, qualified investment counselor (As with any other professional service, confirm their track record and referrals).

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Friday, October 29, 2010

Democracy's Death Spiral is a positive feedback loop between ever-greater concentrations of wealth and the ever-higher costs of retaining political power.

Positive feedback loops lead to "death spirals" in which destructive forces reinforce each other until the dynamic implodes. One example is an "arms race" in which ever more costly and complex weapons systems must be matched lest one nation in the race fall behind.

Since the number of weapons and their cost are essentially unlimited, then the race continues until one contestant is bankrupted.

Though many would claim it is a simplification, this dynamic was at the root of the Soviet Union's collapse: as the U.S. embarked on a massive expansion of its military and technological power, the Soviet Union exhausted its much smaller resources attempting to keep up.

Though statistics from the Soviet era are not entirely reliable, various scholars have estimated that fully 40% of the Soviet GDP was being expended on its military and military-industrial complex.

The U.S. was spending between 4% and 6% of its GDP on direct military expenditures, even during the height of the Reagan buildup. If you include the Security State (CIA, NSA, et al.), the Veterans Administration and other military-related programs (DARPA, etc.) then the cost was still far less than 10% of GDP.

The greater freedom to exchange information between government-funded research labs, private firms and government-funded universities enabled the U.S. to outdistance the Soviets technologically. Once again a positive feedback loop can be discerned in the way that increased spending on military-related R&D in the U.S. led to increasingly networked nodes of technological advancement which led to greater advances and more spending to develop those technologies.

The U.S. emerged victorious as the sole superpower, but a more closely matched rivalry might have ended with the collapse of both competitors: a Death Spiral of the sort Jared Diamond describes on Easter Island in his book Collapse: How Societies Choose to Fail or Succeed.

In the U.S., the ever-greater concentrations of wealth gathered by an ascendant Financial Power Elite has entered a positive feedback loop with the costs of gaining or retaining political power. The costs of winning an election have skyrocketed to the point that fundraising is the key function of any politico who is not independently extremely wealthy.

This quantum leap up in the costs of gaining or retaining power has forced politicos to curry the favors of those few Elite groups which can give them millions of dollars.

Just as in an arms race, the amounts of money which can be spent on campaigns is essentially unlimited. The explosion of media now requires multi-million dollar campaigns on multiple fronts: broadcast TV, cable TV, mailed flyers, radio spots, promotion campaigns to influence the mainstream media coverage, adverts on the Web and social media campaigns--the list grows longer every year.

Here is the positive feedback loop. Candidate A gains the backing of a Power Elite group (a political action committee or other front) and collects $5 million. As a result of a media blitz, he/she wins.

Between elections, he/she amasses a "war chest" of $5 million from the same donors, guaranteeing that the final cost of the next election will be $10 million.

Potential rivals understand that victory against this well-funded incumbent, no matter how incompetent, will require $15 million. The only sources of that amount of cash are other Financial Power Elites and State-funded fiefdoms like teachers unions, and so each candidate sells their soul to the few "special interests" with deep enough pockets to harvest and contribute millions of dollars.

Now repeat that election cycle a few times and see how quickly the cost rises. The truly pernicious aspect of this positive feedback is this: if wealth wasn't becoming ever more concentrated in the razor-thin slice at the top of the U.S. economy, then politicos couldn't gather huge sums of money from such small groups. They would have to seek a broader base to raise money, and that would dampen the influence of the top donors.

Instead, the cycle grows stronger with each election cycle: to raise the gargantuan sums needed to keep political power, politicos become ever more reliant on a tiny pool of super-wealthy Elites and State-funded fiefdoms.

(In Survival+, I describe the desperate plowing of millions of dollars by public unions and other State-dependent fiefdoms into election campaigns as full spectrum defense of the status quo. When two such fiefdoms are competing for dwindling State resources, I term that Internecine Conflict Between Protected Fiefdoms.)

In other words, the more elections cost, the greater the dependence of politicos on a wealthy Elite. And thus the influence of those Elites over the politicos grows as well.This is how the political machinery of deomocracy gets "captured" by a tiny Financial Power Elite.

But there is another aspect to this feedback loop: the key way to gather more of the national income and restrict competitors is to get the Central State (Federal government) to lower your taxes, raise barriers to competition, award you sweetheart State contracts, and so on: in other words, partner with the politicos who now depend on you for their power to expand your cartel's reach, revenues and profits.

This is the Death Spiral of Democracy. The way to increase the concentration of wealth is to partner with the State so the Central State functionaries and agencies funnel ever-larger shares of the national income to your cartel or quasi-monopoly while the State suppresses or marginalizes potential competitors.

The more wealth you concentrate, then the more political power you can purchase.Indeed, the involvement of the super-wealthy causes the costs of campaigns to rise to levels where politicos have no choice but to become dependent on Power Elites to fund their campaigns.

You see how the feedback works: greater concentratiions of wealth creates greater concentrations of political power, and just as importantly, increases the dependence of the political class on the Financial Power Elites and fiefdoms for their very survival.

Alienating a Power Elite or State-funded fiefdom/monopoly is a death sentence, for all those millions will quickly flow to a political rival.

Now that the Supreme Court has ruled that corporations have the same rights as individual citizens and giving unlimited sums of money to politicos is protected as "free speech," then the Death Spiral of Democracy has no negative feedbacks to restrain its dynamic.

This is how a handful of banks and Wall Street firms over-rode the will of the citizens who expressed their desire to let the banks go bankrupt 600-to-1.

The winner and loser of this Death Spiral are clearly visible: democracy has imploded and concentrated wealth has won.

Lest you consider the bank bailout a now-stale example, consider these recent headlines:

Apologists who claim democracy is basically unchanged abound. The entire goal of a corporate media and State propaganda machine is to obfuscate what is really going on. Apologists ignore $500 million elections, an army of 40,000 lobbyists, and all the other evidence that concentrations of wealth are concentrating political power which they then use to further concentrate and protect their growing share of the national income.

A guest on a recent "Charlie Rose" show (I believe it was the October 25th show) summed up the reality of our "democracy" with an anecdote about President Obama's visit to Wall Street while the bogus "financial reform" bill was in play. The President essentially pleaded with the Wall Street Elite to "please stop lobbying us" about the (already gutted) "reform" bill.

There you have the end-state of Democracy's Death Spiral: "the most powerful elected official in the world" begging Wall Street to stop lobbying its Central State lackeys so visibly, lest the public catch on.

Democracy is already dead in America, but the wizened death-mask offers a useful facade for propaganda purposes. As I noted in The Stealth Coup D'Etat: U.S.A. 2008-2010, The Power Elites are apolitical. They don't care about the color of your uniform; whether you wear a blue shirt or a red shirt is inconsequential.

So please enjoy the bread and circuses of the election which the Central State is holding for your entertainment in the Coliseum. No expense has been spared.

My apologies: due to my workload I have fallen behind on my email once again. Your correspondence is greatly appreciated even when I am unable to respond in a timely manner.

Special podcast: Steve over at Two Beers with Steve was generous enough to invite me back to discuss topics of great importance to both of us and to you: health, diet, fitness and taking charge of our own lives. Please give it a listen: Two Beers with Steve podcast.

If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.

Thursday, October 28, 2010

The Stealth Coup D'Etat in the U.S. (called "The Quiet Coup" by Simon Johnson) was begun long ago, but the takeover reached fruition in the 2008-2010 timeframe.

Please read these brief excerpts from the 1968 classicCoup d'État: A Practical Handbook (by Edward Luttwak) and see if they don't remind you of the United States, circa 2008-2010:

Insurrection, the classic vehicle of revolution, is obsolete. The security apparatus of the modern state, with its professional personnel, with its diversified means of transport and communications, and with its extensive sources of information, cannot be defeated by civilian agitation, however intense and prolonged.

(CHS note: Luttwak referred to the May 1968 general strike in France as an example; by coincidence, the failure of today's general strikes in France to change Central State policy offers a more current example from the same nation.

Any attempt on the part of civilians to to use direct violence with improvised means will always be neutralized by the efficiency of modern automatic weapons; a general strike, ont he other hand, will temporarily swamp the system, but cannot permanently damage it, since in the modern economic setting, the civilians will run out of food and fuel well before the military, the police and allied organizations.

(CHS note: Napoleon famously dissipated a civilian uprising with "a whiff of grapeshot" long before modern automatic weaponry. Organized violence always has an advantage over informally organized violence.)

If a coup does not make use of the masses, or of warfare, what instrument of power will enable it to seize control of the state? The short answer is that the power will come from the state itself.

A coup consists of the infiltration of a small but critical segment of the state apparatus, which is then used to displace the government from its control of the remainder.

Luttwak's first point about the futility of direct insurrection informed my ownSurvival+ critique, which concludes that the only effective means to weaken the Financial Power Elites who have partnered with State Elites is to opt out and assemblevoluntary non-privileged parallel structures which are independent of the Central State and its Power Elites.

As I have sharpened the Survival+ critique (with an eye on a future revision), I have come to see that the term coup d'etat is not cheap theatrics or an analogy for the capture of the Central State by Financial Power Elites, but the accurate description of a long, stealthy infiltration and dominance of the key ministries of the United States government.

In the popular view, a coup d'etat is a sudden event, over in a few hours or at most days, a drama played out in impoverished Third World nations. The stealth coup which has occurred in the U.S. is an entirely different kind of coup--one that has operated in stealth mode for the most part, a process of gradual infiltration and opportunistic grasping of key levers of dependence and control.

But these various policies--lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership--had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits--such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998--were ignored or swept aside.

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry’s ascent. Paul Volcker’s monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative.

The invention of securitization, interest-rate swaps, and credit-default swaps greatly increased the volume of transactions that bankers could make money on. And an aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services. Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.

The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers: no government entity was able to offer an effective response. But that first age of banking oligarchs came to an end with the passage of significant banking regulation in response to the Great Depression; the reemergence of an American financial oligarchy is quite recent.

Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.

Though incisive, Johnson's critique fails to grasp several critical features of the Stealth Coup D'Etat:

1. Once you have control of the financial powers of the U.S. via the tiny Elites of the Congress, the Executive Branch, the Federal Reserve and the U.S. Treasury, then the rest of the government will follow.

To the degree that ownership of the Healthcare cartels is in the hands of the same Financial Power Elite, then the passage of the 2,300 page "Healthcare Reform Bill" in 2010 was simply another way for the Power Elite to expand its share of the national income.

The health of the citizenry or healthcare per se had essentially nothing to do with the passage of this monstrosity. The entire purpose was to increase the Elites' share of the national income by siphoning off an ever-greater share to the "healthcare" cartels.

2. This is how the Stealth Coup D'Etat works: the machinery of governance grinds through a simulacrum of democracy, but it's all for show; the theoretical structures are now completely different from the political realities. The citizens were against the bailout of Wall Street and the money-center banks 600-to-1; they were rightly ignored as inconsequential.

The citizenry replaced the political party leadership of Congress and the Presidency; absolutely nothing changed except the flavor of PR, spin and propaganda. The Power Elites and their Stealth Coup are apolitical. They don't care about the color of your uniform; whether you wear a blue shirt or a red shirt is inconsequential.

Some readers complain I over-use the descriptive word simulacrum, and I have tried to leaven this overuse with synonyms such as facsimile. But the key point to understand (and the goal here is always to reach an integrated understanding) is that there is a difference between formal structures such as democracy and free markets and their political and financial representations.

In other words, the "democracy" that was visible in passing healthcare reform (i.e. the diversion of more national income to a specific set of cartels) was a facsimile of democracy, a shadow of the real thing, a mere representation of true democracy.

This substitution of representation for reality is the key mechanism of the Stealth Coup D'Etat. In the financial fiasco now playing out, actual deeds to notes and property have been replaced with digital representations in a registry owned by the banks: MERS.

"Liberating" Iraq as a laudable goal of an enlightened State was merely a public relations facade for the occupation of a key geopolitical piece of a larger puzzle. The entire war has two components: the actual war on the ground, as revealed by 400,000 "liberated" documents, and the representation of the war in the Corporate Cartel Media and as presented by the Central State ministries.

3. The Stealth Coup can be traced by a simple dictum: follow the money. Once you control the money--the money supply, the manipulation of yields and bond sales, the budgeting and borrowing--then you control everything.

This is how a small Financial Power Elite dominates the vast, sprawling American Empire.

4. I use the term politics of experience in Survival+ (with a credit to its originator, R.D. Laing) to describe the manner in which the apparently depoliticized context of our daily media-saturated lives are shaped by political forces we rarely recognize.

In my critique, I invoke the term parallel shadow structures of privilege to describe the formalized but masked structures of power which operate behind the facades of democracy, free markets, and all the other PR bilge drummed into the minds of the the citizenry by a media cartel which itself has been financialized into a Corporatocracy.

Over time, Americans have come to believe that the current state of governance is "democracy" rather than a mere facsimile of democracy. They have come to believe (those still covered by insurance they don't directly pay for) that the U.S. "healthcare" system is "the finest in the world" when by some metrics it is the worst, most profligate, illness-inducing system imaginable. And so on.

Thus "homeownership" was elevated to quasi-religious status as a means of stripmining assets and income from a larger pool of debt-serfs. Earlier this year I asked a simple question: how much of your household's net income flows to cartels? That would include banking cartels (mortgages, second mortgages, credit cards, etc.), Central State-banking cartels (student loans), agribusiness cartels (fast foods, packaged foods, Monsanto, etc.), energy cartels, sickcare cartels (healthcare insurance, hospital chains, Big Pharma) and so on.

If we consider that much of rent payments flow to the same banking cartels (which is why the commercial real estate sector is imploding--too much debt, etc.), then most of us would find that the majority (or perhaps as much as 90%) of our money goes to a handful of cartels dominated by Financial Elites via the steady financialization of the U.S. economy.

How much of your taxes flow to the same cartels via their partnership/control of State fiefdoms?

If you think the term Stealth Coup D'Etat is overwrought, I invite you to ponder the headline quote from the Freedom Guerrilla weblog: None are so hopelessly enslaved as those who falsely believe they are free.

From the point of view of a deconstructed politics of experience, then the events of 2008-2010 are simply the culmination of a Stealth Coup D'Etat which began with the overt financialization of the U.S. economy and indeed of its entire culture.

My apologies: due to my workload I have fallen behind on my email once again. Your correspondence is greatly appreciated even when I am unable to respond in a timely manner.

Special podcast: Steve over at Two Beers with Steve was generous enough to invite me back to discuss topics of great importance to both of us and to you: health, diet, fitness and taking charge of our own lives. Please give it a listen: Two Beers with Steve podcast.

If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.

Wednesday, October 27, 2010

A new journal that tracks the latest revelations in the foreclosure crisis is now available.

Please welcomeForeclosure Crisis Weekly, a new publication dedicated to documenting the often-amazing foreclosure crisis. Since we can expect the crisis to unfold for years to come, the Weekly will undoubtedly have a reliable source of material for quite some time.

Although many of the real foreclosure stories may appear to be fabrications too outrageous to be true, please note this is a parody.

Special podcast: Steve over at Two Beers with Steve was generous enough to invite me back to discuss topics of great importance to both of us and to you: health, diet, fitness and taking charge of our own lives. Please give it a listen: Two Beers with Steve podcast.

If you would like to post a comment where others can read it, please go toDailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.

Longtime contributor Cheryl A. responded with an excellent question about what some call inflation but which could also be seen as the depreciation of the dollar:

While on one hand I understand the logic of your argument, I have difficulty when I look at the decrease in value of the dollar over the past 80 years ($1 to .05). Why would the elite stop devaluing the currency now?

For an answer, let's look at the Bureau of Labor Statistics' inflation calculator and a chart of the Dow Jones Industrial Average as a handy proxy for the stock market.Let's start at 1913, which is the earliest year the BLS tracks.

It now takes $22 to equal the purchasing power of $1 in 1913 (coincidentally, the year that the banking cartel known as the Federal Reserve was conjured up). Put another way, the dollar has depreciated to about 4.5 cents since 1913.

Cheryl raises a critical point: if the Financial Power Elites allowed the dollar to lose 95% of its value over the past 100 years, why would they decide to hinder inflation/dollar-devaluation now?

If the DJIA had risen 22-fold to match inflation/dollar depreciation, then it would now be around 1,540 rather than around 11,000. The stock market rose about seven times the rate of depreciation, more than offsetting the loss in purchasing power of cash under the mattress.

Interestingly, the 15-year Bear Market 1966-1981 was a period of rampant inflation which reduced the purchasing power value of stocks by 2/3.

This destruction of value led to reduced participation:

Financial Elites' positions in common stocks in that period (if any) suffered the same destruction of value as those held by retail investors.

But as Harun I. noted in our recent email exchange, the Elites tend to place most of their holdings in bonds and preferred shares, which pay a higher dividend than common stock.

While I have no data on what happened to the holdings of the top 1% who own most of the financial wealth during the 1970s, it is quite possible the Elites' suffered dramatic declines in their purchasing power. The market value of long-term bonds were destroyed as inflation ramped up, but those who avoided the long bonds and kept liquid were able to buy long bonds that yielded 15% by 1981.

Imagine earning 15% every year, rain or shine, for 30 years. Those 30-years bonds from 1981 will finally expire next year.

The oil shock and stagflation created a challenging environment for everyone, Elites included, and I think it is reasonable to assume that Elites' fortunes were made and destroyed in a capitalist dynamic: those who stayed in common stocks suffered a 2/3 decline in their real wealth in 15 years, those who stayed in short-term bonds and rode the gold bubble up did well, as did those who bought long bonds in the early 1980s with spectacular yields.

My point is that the Financial Power Elite is not monolithic. Those whose wealth was based on industrial capital saw their wealth decline, and those who rode the financialization of the U.S. economy prospered mightily.

Just as a speculation, I would say mild inflation (2%-3% a year) is acceptable to Power Elites as long as they can get real asset growth that exceeds that by a significant margin.

In a low-growth or declining economy, though, then zero-inflation or mild deflation would be the preferred environment. If we have indeed entered an era of declining GDP, then it will next to impossible to engineer strong gains. Thus the Power Elites strategy would be to engineer mild deflation (-3% annually) which has the effect of increasing their purchasing power by 3% annually.

If interest rates rise as well, then that would be even better: getting 7% yield in a 3% deflationary environment would equal a real return of 10%.

The reason the Power Elites would not favor aggressive deflation is that this would bankrupt the debt-serfs, central State and heavily indebted corporations which service the debt owned by the Financial Power Elites.

This is why a mildly deflationary environment with rising interest rates would be the optimum setting for cash-rich Elites. Some will say that interest rates can't rise in deflationary times, but I would suggest rising rates are not just possible but inevitable if the demand for cash to roll over old debt meets insufficient supply of cash in a deleveraging, crashing-commodities prices, Central-State austerity era.

Reader KH had an astute question about my confusing statements about gold.

There was one bit that I didn't quite understand -- you say that if you had $5bn you would maintain your precious metals positions, but a few lines later you say that the higher the value of assets (i.e. gold), the quicker they will be unloaded for cash. Isn't that an inconsistency? I'd be very grateful if you could explain.

What I should have said was the Power Elites would retain their precious metals positions as a hedge even as the price plummeted. The sellers would be those trying to raise cash to roll over old debt that's coming due, or to raise cash to service the debt thay can't liquidate.

As the CEO of Cantor Fitzgerald said in the current issue of BusinessWeek: "It's hard for bad things to happen when you have no debt." That might just be the quote of the decade.

KH also made an important observation about interest rates and deflation.

You say that "I would sit on my hoard of cash while the selling created a positive feedback loop". Where would you put the cash, because under those circumstances, you wouldn't want to have a few billion dollars in a bank at a time when the banks would be at risk of going bust. Wouldn't the only comparatively safe place be treasuries in the short term? If so, that would drive down interest rates to near zero levels. In a deflationary environment, that could still mean positive real interest rates.

Exactly. This was the point I tried to make in The Con of the Decade (July 8, 2010). Smart money will sit in short-term bonds until interest rates suddenly leap, surprising "everyone," at which point they will shift into long bonds to lock in high returns.

My recent point is that the other "trade of the decade" will be in commodities--but only after prices are smashed by the crash of demand as the global economy enters the Depression which was temporarily delayed by a gargantuan (and unsustainable) surge of sovereign and corporate debt.

Thank you, Cheryl and KH, for excellent questions. Nobody knows what will happen, and these are simply speculations informed by the question: cui bono: to whose benefit?

Special podcast: Steve over at Two Beers with Steve was generous enough to invite me back to discuss topics of great importance to both of us and to you: health, diet, fitness and taking charge of our own lives. Please give it a listen: Two Beers with Steve podcast.

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Monday, October 25, 2010

The key to understanding the inflation-deflation debate is to ask what would benefit the Financial Power Elites who own the debt as opposed to owing the debt.

A number of readers have asked me to weigh in on the inflation-deflation question.To many minds, getting this right is the key to choosing successful investment strategies going forward.

I am going to approach the question with the goal of reaching an integrated understanding, as per my Survival+ analysis, rather than be forced to make a binary choice (either deflation or inflation, or one followed by the other).

I am indebted to correspondents Cheryl A, Harun I., B.C., Chris Sullins and Zeus Y. for sharing their thoughts on this topic, as well as the analyses of Mish Shedlock, John Hussman, Karl Denninger and many others.

I am going to start my analysis by listing what we know. Then I am going to proceed to the key survival+ question of cui bono--to whose benefit? Why does answering this question matter?

Because extreme concentrations of wealth lead to concentrated political influence. Thus we are not dealing with a mechanical system here in which the gears of money supply, pricing of risk, and so on are mechanistically processed as if by "invisible hands;" on the contrary, the hands are quite visible, and the feedback between the political and the financial is self-reinforcing.

Which is a fancy way of saying that the Financial Power Elites (corporatocracy, Plutocracy, rentier-financial Elites, etc.) will look out for their best interests. As Harun I. recently pointed out in our ongoing discussion of Power Elites and systemic risk, the hyper-wealthy are no different than the middle class or indeed any other class in this regard: we're all looking out for our best interests.

The difference is the Financial Power Elites are partnered with (or own) the political class of politicos and high-caste apparatchiks which are tasked with keeping the machinery of governance running smoothly to the benefit of the status quo.

Here is the key point I wish to emphasize: we will not "get" inflation or deflation by chance or mechanistic functions, but by a series of policy choices which will be made to benefit the Financial Power Elites and their functionaries in the Central State.

As I noted in Hyperinflation Is a Political Process (October 21, 2010), any policy which is driving inflation can be reversed politically at any time. Thus there is nothing inevitable in the current system except the following:

Demographics and the intrinsic limits of exponentially rising debt and consumption dictate that the status quo will implode at some point in the near future. Historical cycles suggest the point of implosion will occur around 2021-2022, but nothing is written in stone.

Indeed, were the status quo to transform into a financial and resource-consumption model that was truly sustainable, then the implosion could be avoided altogether. But the concentrations of wealth and political power are so profound that such a transformation seems unlikely, unless the Power Elites concluded such a radical transformation was in their best interests.

So rather than look at inflation-deflation as mechanical models, I ask: which one would benefit those with the wealth and power? If we answer that, then we can predict which will occur, regardless of what various models predict.

I would like to point out that defining deflation and inflation can end up being somewhat like defining love; the words are inadequate to the task of parsing out the various permutations.

Thus I prefer the more discrete term purchasing power which doesn't demand a mechanism for price discovery. It simply asks if your currency (or gold, quatloos, etc.--whatever "money" you are measuring) can buy more or less of items such as oil, grain, coffee, sugar, rental housing, consumer luxuries, and so on.

This distinction helps us avoid various rabbit holes associated with "inflation." According to conventional thinking, inflation is a monetary phenomenon, that is, "too much money chasing too few goods."

But this is easily confused with currency depreciation, which also causes prices to rise in the sense that our money buys less oil, etc. than it did in the past. This is not the same as the inflation caused by an economy being flooded with cash.

We also have to make some distinctions between asset inflation and standard-issue inflation, in which prices and wages may enter a wage-price spiral. Assets can rise in price and purchasing power even as the "real economy" stagnates.

Lastly, there are our old free-market friends, supply and demand. If oil is suddenly in short supply due to war or other severe disruption, then the rise in price is not a result of an increase in money supply (inflation) or currency devaluation; the fact remains that it takes more currency buy a gallon of petrol than it did before the supply disruption, even if there is no inflation and the currency has remained stable against other currencies and gold.

All this is to say that trying to parse out the meanings of these "hot button" words and all the dynamics can end up being more distracting and confusing than enlightening.

On to what we know.

1. We know that wealth is highly concentrated in the U.S., and becoming more concentrated with the passage of time. I often publish this chart to demonstrate how the majority of Americans have few if any financial assets.

Income inequality has grown massively since 2000. According to Harvard Magazine, 66% of 2001-2007's income growth went to the top 1% of Americans, while the other 99% of the population got a measly 6% increase.

2. The nation's economy is heavily dependent on two revenue/consumption streams: the top slice of households and the Federal Government, which is borrowing roughly 12% of GDP (borrowing $1.6 trillion, GDP of about $14 trillion) annually to prop up the economy.

There were 51,487,282 housing units with a mortgage and 23,875,803 Housing units without a mortgage as of 2008.

As of the end of 2009, total equity in household real estate was a paltry $6.24 trillion of which about $5.25 trillion was held in free-and-clear homes (32% of all household real estate, i.e. 32% of $16.5 trillion).

That leaves about $1 trillion--a mere 1.85% of the nation's total net worth-- of equity in the 51 million homes with mortgages.

Their 7% share of the nation's financial wealth? That is 7% of $45 trillion, or $3 trillion, including all stocks, bonds and securities in IRAs, 401K retirement funds, savings and other accounts.

That's $3 trillion held by 108 million households, compared to $32.4 trillion held by the top 5% of households (72% of $45 trillion), roughly 7 million households.

6. Though the Federal Reserve can create trillions of dollars in new credit, and lower interest rates to near-zero, it cannot control where that credit flows. As others have documented, most of the liquidity created by the Fed has not flowed into the real economy; it has flowed into the banks to bolster their reserves or into speculative chasing of yields in risk-assets.

As Mish has pointed out, neither the Fed nor the banks can force people or enterprises to borrow money. Therefore "printing money" via credit creation does not mean vast new floods of money gush into the real economy. On the contrary:

7. The flood of global quantitative easing/liquidity/credit has flowed into risk-assets as zero-interest rate policies (ZIRP) have created a mad rush for yield.Rather than create new borrowing and spending in the real economy, as the Fed claims was the intention of its policies, the trillions of dollars, euros, yuan, etc. have flowed into emerging markets (many of which are up fantastic percentages in the past few years), commodities, corporate debt (which as surged to $7 trillion in the U.S.), Chinese real estate and developed-nation's equity markets.

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

9. You cannot control everything in global markets. The reason for this is that other nations trade with the U.S. and they are pursuing their own best interests. Also, there are still relatively open markets for currencies and commodities on a global scale, and these cannot be set by political fiat, though the machinery of the Fed and Treasury aims to manipulate or direct these markets to meet the goals of those setting the agendas for the Fed and Treasury.

As I believe John Hussman pointed out, in an unfettered market then countries with high needs for capital and/or domestic inflation would pay substantially higher interest rates than other economies. But with quantitative easing and ZIRP the Central States' policy of choice, then bond yields and prices are locked down and unable to respond in a market fashion (that is, discovering and pricing risk and return).

That leaves all the adjusting to the foreign exchange markets. China's peg to the dollar, for example, is one attempt to control everything: the currency's value, China's bond yields and its domestic money supply.

But the net result is that "hot money" has flooded into China's real estate market, crating a monumental bubble. So you can't control everything, even if you are a Central State with authoritarian controls over Central Banking and currency pegs.

So where does all this leave us? With this question: if you owned 93% of the net worth in the U.S., what would benefit you most?

Let's ask two other questions: who benefits from inflation and who benefits from deflation (increasing purchasing power as borrowing and economic activity decline).

In broad brush strokes:

Those with massive debts benefit from inflation as they can pay down their debt with "cheaper" money. This is the reason many people give for why the Federal government loves inflation and why the Fed is striving to create it: so the Central State can pay the interest on its fast-rising debt without crimping future spending.

The trick here is that wages and revenues have to rise in tandem with costs. If wages/income/tax revenues stagnate as prices rise (purchasing power declines) then everyone's net income left to service debt falls.

As noted above, median household incomes are declining.

Conversely, those with fixed incomes benefit from deflation. If everything you need gets cheaper with time, then your cash is earning a nice yield even if its nominal yield is zero.

The problem is incomes (and tax revenues) also tend to decline in deflation, so debts become ever more burdensome. This is the reason usually given for why the status quo fears and loathes deflation.

But remember: every debt is someone else's asset. If I owe you $300,000 for a mortgage at 5%, and next year inflation enables me to pay you off with one month's salary, then your asset has lost most of its purchasing power. My debt is gone and you have seen your assets wiped out.

My conclusion: the idea that those owning most of the financial and property assets would welcome inflation makes little sense. If inflation eats away the value of debt, it also eats away the value of debt-based assets (i.e. the mortgage I owe you).

For the same reason, I can't see the value of a depreciating U.S. dollar to those who own 93% of all financial assets. Sure, these Elites have overseas assets, gold, etc., but a substantial percentage of their wealth is still in dollar assets. For them to allow or welcome the destruction of the dollar--that makes no sense. On the contrary, their purchasing power rises along with the dollar.

The Financial Power Elites have good reason to prefer higher interest rates and low or no inflation, as I described in The Con of the Decade (July 8, 2010).

The ideal scenario for the Financial Power Elites which own the debt is modest deflation, as that increases the purchasing power of their income stream. The ideal setup is a nation/world of debt-serfs who are still able to service their debts and pay their taxes. The only real danger is if debt service and taxes become too burdensome and they revolt.

So the Financial Power Elites do have to care about the top 20% below them, as thesetax mules pay most of the Central State's taxes. That's important because the Power Elites will likely end up owning high-yield long-term Treasury bonds.

They also have to care a bit (but not too much) about the bottom 60% who own no assets to speak of, as this class could create political turmoil were they to recognize the hopelessness of their serfdom. So the Power Elites will support bread-and-circuses: cheap entitlement programs like food stamps, and abundant entertainment (cable TV and Internet). This combination has a long history of success in placating and distracting the masses.

Out-of-control costly programs like Medicare will be pared back. They are only valuable as ways of diverting the national income into cartels owned by the Power Elites. To the degree they threaten to disrupt the overall financial status quo, they will be pared down via reduction of benefits.

If commodity prices get too outrageous, then the Power Elites will support Central State rationing and other programs which ensure the bottom 60% will have few reasons to rebel and plentiful reasons to silently, passively comply.

All the above leads me to this Grand Strategy for the Financial Power Elites. Most of us have a difficult time putting ourselves in the shoes of those tasked with maintaining the private purchasing power of $500 million, or $5 billion, and the inability to think on this scale leads to obsessive focus on financial minutae.

If I had $5 billion, and the political power that goes with spending a tiny sliver of that on political donations and lobbying, then here's what I would do, as an entirely "obvious" Grand Strategy:

1. I would slowly liquidate my common-stock equity and long-bond positions, and maintain my precious-metals positions (preferably ownership of the mines than the bullion) and my preferred stock in global corporations.

2. I would engineer a global recession that implodes all the asset bubbles around the world--Chinese real estate, commodities, emerging market equities, etc., as demand collapsed and supply was suddenly revealed as overly abundant. (Please see my oil "head-fake" entries for how this works: Oil: One Last Head-Fake? (May 9, 2008)

This would create a mad dash for dollars and other cash to pay down debt taken on in the "easy money"/ZIRP era (i.e. 2008-2010), and lead to wholesale dumping of all assets which still have value. The higher the value (i.e. gold) the quicker they will be unloaded for cash: for instance, oil and energy-based equities.

3. I would sit on my hoard of cash while the selling created a positive feedback loop and prices plummeted in a downward panic spiral.

4. As net worth vanished in the tens of trillions of dollars/yen/yuan/euros, interest rates would rise dramatically as those desperate for funds compete for dwindling free cash. Revenues of oil exporters and other exporters crash, drying up a once-reliable source of cash.

5. When premium real estate properties and equities are selling for 10%-20% of their pre-crash valuations, I will begin buying. I won't buy long-term bonds until the yields skyrocket; then I will jump in with all four feet.

6. As the long-term shortage of commodities eventually re-asserts itself, then I (and my other Financial Power Elites cohort) will own most of what the world needs to function, including the Central State tax revenues which will increasingly be directed to making interest payments.

7. I will be a strong supporter of food stamps and other low-cost rebellion-reduction programs, and "soft" and "hard" power to enforce my ownership of assets which I purchased.

8. As interest rates rise, the U.S. dollar will strengthen, further increasing my purchasing power.

9. I will oppose inflationary policies as needless reductions in my purchasing power. I don't owe debt, I own debt as an asset.

Bottom line: expect a crash in commodity prices and other asset bubbles, a much stronger dollar and rapidly rising interest rates. I am playing it as it lays, and this is precisely what I expect to unfold between 2010 and 2014.

Special podcast: Steve over at Two Beers with Steve was generous enough to invite me back to discuss topics of great importance to both of us and to you: health, diet, fitness and taking charge of our own lives. Please give it a listen: Two Beers with Steve podcast.

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Saturday, October 23, 2010

When financial markets have become riddled with fraud, embezzlement and corruption that goes unpunished, then institutional players will avoid that market as crooked: the well has been poisoned.

The full consequences of what I termedThe Rot Within: Our Culture of Financial Fraud and the Anger of the Honest (October 15, 2010) are now unfolding: the well has been poisoned. One of my most astute correspondents made a critical observation that I've seen nowhere else: once a market has been poisoned by fraud which goes unpunished, then institutional players will avoid that market as untrustworthy.

Without institutional trust and participation, the market then withers on the vine-- exactly what has happened to the U.S. mortgage securities market. The market for mortgage-backed securities has vanished, except for one player: the Federal Reserve, which has bought a staggering $1.2 trillion in the past 18 months to create the facsimileof an active market.

The well has been poisoned. The only mortgages being traded are those 100% guaranteed by the U.S. government: in effect, the risks intrinsic to a corrupted market have been shifted to the taxpayers, while the criminals who profited from the fraud and embezzlement got away scot-free.

When I was in the Wall Street game, our small-cap fund was for a time in the top 5% of performers. I got bored and left, which is a longer story. Anyway, I observed a phenomenon about fraud. First it happened. Then it was widely publicized. Then it was prosecuted, and some big names were jailed. At that point, it was safe to go back into the water.

This happened in a few industries prior to the mid-1990s, at which point basic law enforcement was neutered and there were no more fraud prosecutions that mattered. I have always thought that the lack of fraud prosecutions for Internet/telecom fraud was a significant reason why the NASDAQ has never made a significant recovery to anything close to its peak reached in March 2000.

Watch carefully on the foreclosure frauds. If real jail terms are handed out to some (doesn't need to be all) big players, that will be a green flag. The public at large won't see it or believe it, but the professionals will. I am not predicting that this will happen. In fact, I'm quite skeptical that it will. However, any intelligent skeptic considers all the possibilities.

This is why no institutional investor will touch private-market mortgage securities with a 10-foot pole. The U.S. government and the Fed had a stark choice: either impose the rule of law and indict and convict hundreds, if not thousands, of people who perpetrated and profited from the systemic fraud and embezzlement at the heart of the mortgage and mortgage-securities industries, or socialize the corrupted, poisoned markets and use taxpayer funds to prop up the wizened shell of a stripmined market and reward the criminals with freedom.

They chose to reward the criminals and prop up a simulacrum market with only one buyer: the Federal Reserve. You can go to the the Fed's balance sheet and see the $1.2 trillion in mortgage-backed securities it owns. There is no effort to hide the brazen socialization of what once was a private-sector, free market.

When the well has been poisoned, the only players dumb enough to drink from it are the taxpayers, who have no choice as the politico toadies of the investment banking/financial Power Elites have funneled some $13 trillion in cash, backstops and guarantees into their "partners" who fund their campaigns and write the laws via their lobbyist proxies.

If you are so confident in the "transparency" and trustworthiness of the mortgage securities market, please tell us how many private institutional investors are buying mortgage securities which aren't 100% guaranteed by the Central State.

The same distrust has poisoned U.S. stock markets. The high keening cry to "get into the market while stocks are cheap" which has been spewed daily for months on end on network TV and other channels of raw propaganda has been ignored by the "retail investor," a.k.a. the top 20% of Americans who have financial wealth to preserve and invest.

For 24 straight weeks, retail investors have been pulling tens of billions of dollars out of U.S. mutual funds and plowing hundreds of billions into low-yield Treasury bonds.

Why? Because they sense the stock market is hopelessly, deeply corrupt and by comparison Treasuries are trustworthy. You won't make a lot of yield in Treasuries, thanks to the Fed's zero-interest rate policy (ZIRP) which is designed to drive money into risky assets, but then you won't lose 40% like you did in 2008-09 or 2000-2002 in the stock market.

We can also see how insiders are responding to the knowledge that the well has been poisoned: they're selling 500 shares for every share they buy. This unprecedented cascade of insider selling has been noted elsewhere many times, as has the declining expectations for the "recovery" of U.S. CEOs.

Those who know the most are selling their shares as fast as they legally can, and are publicly expressing their lack of faith in the tricked-up "recovery."

The U.S. financial markets have been poisoned, with long-term negative consequences. Only crooks, fraudsters and "marks" (those who still believe the propaganda about the "recovery" and "stocks are cheap" poison) will be left in a stock market propped up by the same socialization of risk which keeps the flimsy facade of a mortgage market from crumbling. High-frequency trading machines create the illusion of a market, and State intervention via proxies and other corrupt games provides the liquidity needed to fund the facsimile of a "rising market" and a "recovery" in the U.S. economy.

But the public isn't buying the fraud any longer; they finally "get it": The well has been poisoned and only a fool drinks from a poisoned well.

This is why we can safely anticipate a hollowed-out stock market which trades at a steep discount to its present propped-up levels in the years ahead--until the crooked players are indicted and the financial markets thoroughly cleaned. That will take political will which is completely lacking in the Demopublican-Republicrat status quo. For more on this, please read:

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